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Chapter 7 The Firm. Business Firm. Employs factors of production Produces goods and services Sells to consumers, other firms, or the government We work for and buy from firms. Market. Two sides Buyers Utility is major decision making device Sellers How do they make decisions.

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Chapter 7 The Firm

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Chapter 7 the firm

Chapter 7The Firm

Business firm

Business Firm

  • Employs factors of production

  • Produces goods and services

  • Sells to consumers, other firms, or the government

  • We work for and buy from firms



  • Two sides

    • Buyers

      • Utility is major decision making device

    • Sellers

      • How do they make decisions

How do the two sides come together

How do the two sides come together?

  • Market Coordination

    • Invisible Hand (Adam Smith)

    • Market guides individuals into activities at which they are the most efficient

    • Pushes sellers to produce certain things and buyers to instruct what to produce

    • Equates supply and demand

How does the firm decide what to produce

How does the firm decide what to produce?

  • Managerial Coordination

    • Guides individual firm production decisions

    • Thus…invisible hand of the firm

Why follow this invisible hand

Why follow this invisible hand?

  • Firms are formed because greater benefits of working as a team than working as individuals

Problem with teamwork

Problem with teamwork

  • Shirking

    • Putting forth less effort than your originally agreed to

    • Problem because shirker gains ALL benefits from shirking but costs are spread over the entire team

Can shirking increase or decrease

Can shirking increase or decrease?

  • Yes!!

  • As the benefits of shirking increase so does the amount

  • If the shirker must bear the full cost of shirking then shirking will decrease

How can we decrease shirking

How can we decrease shirking?

  • Manager’s duty or MONITORING

  • Reward productive workers and punish shirkers

  • Preserves the benefit of team production

  • Reduces the benefits of shirking

Who monitors the monitor

Who monitors the monitor?

  • Salary usually tied into production

  • Called Residual Claimant

    • Person who shares in the profits of the firm

    • More shirkers?? Less Production…so less pay for monitor

Another way to ward off shirking

Another way to ward off shirking?

  • Pay higher than equilibrium wages

  • Decreases shirking because cost of losing job is greater.

  • Don’t need monitor because high wage makes worker monitor themselves

  • Called efficiency wage theory

Why do people submit to being monitored

Why do people submit to being monitored??

  • Monitoring decreases shirking

  • Monitoring increases benefits of teamwork

  • Monitoring maximizes benefits that can be achieved

Objective of the firm

Objective of the firm

  • Profit Maximization

  • Now…want to move to the Firm to see how they achieve this objective

Chapter 8 production and costs

Chapter 8Production and Costs

© South-Western College Publishing 1998

Cost side

Cost Side

  • Explicit Cost

    • Actual money is exchanged

    • COST

  • Implicit Cost

    • Value of resources used in the production or acquisition of a good

    • No monetary payment




  • In order to have a cost, sacrifice must have taken place

  • Forfeited something else

  • No money must change hands for sacrifice to take place



  • Two types

    • Accounting

      • Difference between total revenue and explicit costs

      • Acct Profit = TR – EXPLICIT COSTS

    • Economic

      • Difference between total revenue and total cost (implicit and explicit)

      • Econ Profit = TR – Explicit Cost – Implicit Cost

Which do you think is lower

Which do you think is lower??

  • Economic Profit

  • Usually lower but never higher

  • How can it be “usually” lower?

  • Implicit cost can equal 0 so accounting and economic profit would be equal

Accounting and economic profit

Accounting and Economic Profit

Zero economic profit

Zero Economic Profit

  • Total Revenue-explicit cost-implicit costs = 0

  • Also called NORMAL PROFIT

  • Equilibrium of profit for the firm

  • Would we want zero accounting profit?

  • NO!!! Implicit costs would not be covered

Sunk versus fixed costs

Sunk versus Fixed Costs

  • Sunk

    • Incurred in the past

    • Cannot be changed by a current decision

    • Cannot be recovered

    • Example: Time spent in school

    • Can’t recover so let it go…Release it

  • Fixed

    • Possibility of recovering some money for selling the good

    • Example: Land, equipment…



  • Takes time to produce

  • Costly to produce

  • Direct link between production, costs, and time

Two types of time

Two types of time

  • Short Run

    • Fixed and variable inputs

  • Long Run

    • All inputs are variable

Short run

Short Run

  • Fixed input

    • Quantity can not be changed

    • Independent of output produced

    • Example: Building, land…

  • Variable input

    • Quantity can be changed as output changes

    • Example: Labor



  • Fixed Cost (FC)

    • Associated with fixed inputs

    • Do not change with output

    • Example: Insurance premiums

  • Variable Costs (VC)

    • Associated with variable inputs

    • Changes as output changes

    • Example: Hire more people and must pay more wages

Total fixed cost

TotalFixed Cost

Total variable cost


Periods of production inputs and costs

Periods of Production, Inputs, and Costs

Total costs

Total Costs

  • Variable Cost + Fixed Cost

Total cost


Other costs of importance

Other costs of importance…

  • Average Variable Cost (AVC)

  • Average Fixed Cost (AFC)

  • Average Total Cost (ATC)

Average variable cost


Average fixed cost

Average FixedCost

Average total cost

Average Total Cost

Marginal cost

Marginal Cost

  • Change in TC that results from a change in output

  • Additional cost of producing an additional unit of output

Why change in total cost or total variable cost

Why Change in Total Cost or Total Variable Cost????

  • Since total fixed cost doesn’t change the “additional” total fixed cost is zero

Marginal costs

Marginal Costs

In class exercise 9 using the knowledge

In-class exercise #9Using the knowledge

Shapes of curves

Shapes of Curves

  • Law of diminishing marginal returns

    • As larger amounts of a variable input are combined with fixed inputs eventually the Marginal Physical Product (MPP) declines

Marginal physical product mpp

Marginal Physical Product (MPP)

  • What is the variable input?

  • What is the variable cost?

Chapter 7 the firm 1338150


  • As more labor (VARIABLE INPUT) are added to land (FIXED INPUT) the variable inputs would yield smaller and smaller additions to output

Marginal physical product

Marginal Physical Product

Crowding problem

Crowding Problem

  • The point at which MPP declines

  • Shows the law of diminishing returns

Average physical productivity

Average Physical Productivity

  • Output divided by Inputs (usually labor)

  • Good for comparing firms or countries.

So find that

So find that…

  • MC and MPP are related

  • What is the relationship?

In class exercise 10 does mpp show diminishing returns

In –class exercise 10 Does MPP show Diminishing Returns???

Law of diminishing marginal returns

Law of Diminishing Marginal Returns

Marginal cost1

Marginal Cost

Does this relationship make sense

Does this relationship make sense?

  • Yes..

  • If productivity increases what would happen to costs??

    • Decrease (MPP increase & MC decrease)

  • Productivity decreases??

    • Increase (MPP decreases & MC increases)

Mpp determines shape of mc

MPP determines shape of MC

  • MPP must have a declining part because of diminishing returns

  • Can also define MC as:

In class exercise 11

In-class exercise 11

How do we calculate these costs??

Give two ways to get to the cost…

Average marginal rule

Average-Marginal Rule

  • Can use to see what the ATC and AVC curve look like

  • Tells us what happens when MC is above or below the “average” curves

  • If MC is above AVC and ATC

    • AVC and ATC are rising

  • If MC is below AVC and ATC

    • AVC and ATC are falling

From average marginal rule can infer

From Average-Marginal Rule can infer…

  • MC intersects the AVC and ATC curves at their MINIMUM POINTS

  • Cannot infer anything about AFC

Average and marginal cost curves

Average and Marginal Cost Curves

Average and marginal cost curves1

Average and Marginal Cost Curves

Chapter 7 the firm 1338150


  • MC gains it shape from???

    • MPP and law of diminishing marginal returns

  • MC below ATC: What is ATC curve doing?

    • Falling

  • MC above ATC: What is ATC curve doing?

    • Rising

Average and marginal cost curves2

Average and Marginal Cost Curves

Tying products to costs

Tying Products to Costs



Variable Input

When MC is below



Production in the

short run: at

least one fixed input

When MC is above



Variable Input


Now switching to the long run

Now switching to the Long Run

  • When does Long Run start?

    • As soon as all inputs (costs) are VARIABLE

    • No fixed costs

  • Important curves

    • LRTC

    • LRATC

    • LRMC

Short run vs long run

Short Run vs. Long Run

  • Short Run assumes FIXED plant size

  • Each plant size has a unique ATC curve associated with it

    • SRATC

  • LRATC combines all the SRATC curves

  • Which points of the SRATC???

  • Minimum points

Why minimum

Why minimum?

  • LRATC shows the lowest average cost at which a firm can produce any given level of output

  • LRATC is the lower ENVELOPE of the SRATC curves

  • Called envelope curve

Long run average total cost curve lratc

Long-Run Average Total Cost Curve (LRATC)

Isn t the lratc curve smooth

Isn’t the LRATC curve smooth??

  • Yes!!

  • Have infinitely many SRATC curves so it would be smooth if use all curves

  • Each SRATC curve touches the LRATC curve only once

Shape of lratc

Shape of LRATC

  • U-shaped

  • Decreasing, Flat, then Increasing

  • Important when finding optimal long run output level

Long run average total cost curve lratc1

Long-Run Average Total Cost Curve (LRATC)

Economies of scale

Economies of Scale

  • Downward part of LRATC

  • Average costs decrease as output increases

  • If have a 1% increase in input usage what happens to output??

    • Increases by MORE than 1%

  • Specialization

Constant returns to scale

Constant Returns to Scale

  • Flat portion of LRATC

  • Costs remain the same as increase output

  • If have a 1% increase in input usage what happens to output??

    • Output increases by EXACTLY 1%

  • First point of constant returns to scale is called MINIMUM EFFICIENT SCALE

Diseconomies of scale

Diseconomies of Scale

  • Upward sloped portion of LRATC

  • Costs are rising as we increase output

  • If have a 1% increase in input usage what happens to output?

    • Increases by LESS THAN 1%

  • Why???

    • Firm too large (bad communication or coordination problems)

Long run average total cost curve lratc2

Long-Run Average Total Cost Curve (LRATC)

Are economies diseconomies and constant returns to scale in sr lr or both

Are economies, diseconomies, and constant returns to scale in SR, LR, or both???


  • Why?

    • Inputs necessary for production are able to be changed

    • No fixed inputs

Is this the same as diminishing returns

Is this the same as diminishing returns?

  • NO

  • Diminishing returns is from using ONE plant size intensely

    • Short run

  • Economies of scale is from CHANGING plant size

    • Long run



  • Economies of Scale

    • LRATC falling

  • Constant Returns to Scale

    • LRATC flat

  • Diseconomies of Scale

    • LRATC rising

Why does economies of scale exist

Why does economies of scale exist?

  • Large firms offer more opportunity for workers to specialize

  • Growing firms can take advantage of efficient mass production techniques

    • Smooth cost over more units produced

Why does diseconomies of scale exist

Why does diseconomies of scale exist?

  • Communication problems

  • Shirking

  • Management problems

Why is minimum efficient scale important

Why is minimum efficient scale important?

  • Lowest output level at which ATC are minimized

  • Which has a cost advantage??

    • Small firm at minimum efficient scale point

    • Larger firm producing more output but still within constant returns to scale area

    • Neither

Long run average total cost curve lratc3

Long-Run Average Total Cost Curve (LRATC)

Minimum efficient scale for six industries

Minimum Efficient Scale for Six Industries

Where would you expect to find less firms using mes

Where would you expect to find less firms? (using MES)

  • Firms with higher MES

  • Why??

    • Produce until MES

    • If MES is higher then each firm will be producing more…so need less firms to cover quantity wanted by economy

  • Many SHOE companies (MES = .2)

  • Few REFRIGERATOR companies (MES = 14)

Efficient number of firms

Efficient Number of Firms

  • 100 divided by MES

  • 100% of goods are wanted by consumers

  • MES is the percentage of consumption each firm will provide

  • Cigarette firm’s MES = 6.6

    • Need 15 firms

  • Petroleum firm’s MES = 1.9

    • Need 52 firms

  • Thus a larger MES means less firms needed

What cause srtc lrtc and mc to shift

What cause SRTC, LRTC, and MC to shift?

  • Taxes

    • Does it affect FC??

      • Only if it is a lump sum tax (tax for existing)

      • If it is a per unit tax then FC doesn’t change

    • How does it change curves??

  • Input prices

    • How does it change curves??

  • Technology

    • Either improves production process (use less inputs) or lower input prices

    • How does it change curves??

Homework due monday may 19th

Homework due Monday May 19th

  • Chapter 8

    • Questions: 3, 5, 10, and 11

  • Working with numbers and graphs

    • Questions 3, 6, and 7

In class exercise 12

In-class exercise 12

Do we understand Chapter 8??

Chapter 10

Chapter 10




  • One seller

    • Firm is the industry

  • No substitutes for good

  • Many barriers to entry

Government can grant monopoly power in three ways

Government can “grant” monopoly power in three ways…

  • Public franchise

    • Exclusive provider

      • Power companies, water companies

  • Patents

    • Exclusive provider for 17 years

    • Encourages people to invent new things

      • Zantac, Tagament

  • Licenses

    • Must have to operate

      • Cabs in New York City

Monopolies exist because

Monopolies exist because:

  • Legal mandate

    • Government allows or doesn’t allow you to operate

  • Economic rational

    • Natural Monopolies

      • One firm can produce more efficiently than many

    • Exclusive ownership of resource to make the good

Two types of monopolies

Two types of Monopolies

  • Government monopolies

    • Legally protected from competition

  • Market monopolies

    • Protected from competition due to economies of scale

Price maker

Price maker

  • Firm is the market

  • Firm has some control over the price it sets

  • Law of Demand still hold

    • Price increases leads to less quantity demanded

Demand curve

Demand Curve

  • Remember the individual firm is the market

  • What does the demand curve look like??

    • Downward sloped

    • Want to sell more must lower the price



What differs here from perfect competition

What differs here from Perfect Competition??

  • Price doesn’t equal MR!!!

    • Price > MR

  • Monopolist’s demand curve and marginal revenue curves are DIFFERENT

  • After the first point Marginal Revenue falls twice as fast as Demand



Demand and marginal revenue curves

Demand and Marginal Revenue Curves

Chapter 7 the firm 1338150


  • Profit Maximization

  • What is the profit maximization rule?

    • MR = MC

  • Want to charge the highest price per unit of quantity sold

Monopolist s profit maximizing price and quantity of output

Monopolist's Profit-Maximizing Price and Quantity of Output

Three cases

Three cases

  • P > ATC

  • P < ATC

  • P=ATC

  • Where is AVC??

    • Since monopoly is the industry no need to segment total cost

    • If suffer a loss can just increase prices to cover the loss

Monopoly profits and losses

Monopoly Profits and Losses

Differences between monopoly and perfect competition

Differences between monopoly and perfect competition

  • P = MR for perfect competition but P > MR for monopoly

  • P = MC for perfect competition but P > MC for monopoly

  • Monopolist can change prices



  • Both try to maximize profits

  • Both are constrained by their demand curves

  • Both equate MR and MC

Long run profits

Long Run Profits

  • Perfect Competition

    • Zero Economic Profit (normal profit)

  • Monopoly

    • No entry

    • Profits can be reduced in two ways

      • Capitalization of profits

      • Monopoly rent seeking

Capitalization of profits

Capitalization of Profits

  • Firm owner eventually may sell the business

  • When sell…include profits into the price

    • Include in TFC

  • New owner will face a higher ATC than previous owner

    • Includes old owner’s profits

  • Increase in ATC eliminates profit for new owner

Capitalization of profits1

Capitalization of Profits

Economic rent

Economic Rent

  • Profits that can’t be reduced by new entrants

  • Payment in excess of opportunity cost (profit)

  • May bring about Rent Seekers

    • Try to find markets that can gain monopoly status

    • Time and resources expended to try to get monopoly reduces economic rent

Monopolies are inefficient compared to perfect competition

Monopolies are inefficient compared to Perfect Competition

  • Welfare cost of monopoly

    • Lower levels of output produced with monopoly than perfect competition

    • Perfect competition produce where P=MC

    • Monopoly produce where MR=MC and P > MC

    • Welfare cost is about 1% of total output

  • Rent seeking is socially wasteful

    • Use resources not in production but to gain monopoly power

Welfare cost and rent seeking as social costs of monopoly

Welfare Cost and Rent Seeking as Social Costs of Monopoly

X inefficiency


  • Monopoly has no competition

  • No incentive to operate at lowest cost

Does monopolist have to charge same price to everyone

Does monopolist have to charge same price to everyone?

  • No!!

  • Called Price Discrimination

  • Three types

    • First degree (perfect price discrimination)

    • Second degree (bulk pricing)

    • Third degree (group pricing)

Perfect price discrimination

Perfect Price discrimination

  • Highest price willing and able to pay is charged to each person

  • Price determined by placement on demand curve

  • Discrimination among units

    • Ex. Schools

Bulk pricing

Bulk Pricing

  • Different prices for different quantities sold

  • Discrimination among quantities

  • Ex. costco

Group pricing

Group Pricing

  • Different prices for different segments of the market

  • Ex. Senior citizen discounts, coupons, different seats in movie or plane…

Why price discriminate

Why Price Discriminate?

  • To gain some of the consumer surplus lost when charge everyone the same price

  • If successfully perfectly price discriminate

    • P=MR for all units sold

    • MR and TR increase

    • Eliminate consumer surplus

Why doesn t everyone price discriminate

Why doesn’t everyone price discriminate?

  • Seller must be a price maker

  • Seller must know each consumer’s willingness to pay

  • Must be impossible for consumers to resell to others

    • Arbitrage

    • Buy for a low price and sell at a higher price

Does a monopolist exhibit resource allocative efficiency

Does a monopolist exhibit resource allocative efficiency?

  • Perfect competition does!!

    • P = MC

  • Monopolist doesn’t!!

    • P > MC

  • Perfectly Price Discriminating Monopolist does!!

    • P = MC

Comparing p c firm single price monopolist perfectly price discriminating monopolist

Comparing P. C. Firm, Single-Price Monopolist, & Perfectly Price-Discriminating Monopolist

So does one person paying high prices mean that another can pay low prices

So does one person paying high prices mean that another can pay low prices??

  • No!!

  • Perfect Price Discrimination means that each person pays the highest price they are willing and able to pay

Would firms rather be a monopoly

Would firms rather be a monopoly?

  • Yes!!

  • Rent seekers try to “buy” monopoly positions.

  • Why?

    • Fewer constraints on production behavior

    • Ability to charge different prices to different segments of the population

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